ASSET PROTECTION PLANNING

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Barbra Jordan
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1 I. INTRODUCTION ASSET PROTECTION PLANNING Gideon Rothschild Moses & Singer LLP A. The Current Litigation Environment Creates Greater Exposure to Risk of Loss Than Ever Before: 1. Expanded theories of liability 2. Higher and higher jury awards 3. Unpredictable judges and juries B. Traditional Forms of Protection Have Become Inadequate 1. Insurance a. Exclusions b. Policy limits c. Solvency of insurer d. Policy lapses 2. Incorporation a. Piercing the corporate veil b. New theories of shareholder/officer liability C. Candidates for Asset Protection Planning 1. Professionals 2. Corporate officers and directors 3. Fiduciaries 4. Real estate owners 5. Individuals exposed to lawsuits arising from claims alleging negligent acts, intentional torts (i.e., discrimination, harassment, libel, etc.), or contractual liability Gideon Rothschild

2 6. Individuals seeking a prenuptial alternative D. Asset Protection Is Not New 1. Incorporation of business activities 2. Formation of LLC's, LLP's, LP's 3. Offshore trusts have been long used to avoid forced heirship and expropriation 4. Exemption and pre-bankruptcy planning E. Asset protection is part of an overall wealth preservation process including: 1. Financial planning 2. Insurance planning 3. Income tax planning 4. Estate tax planning II. FRAUDULENT TRANSFER ISSUES A. Every asset protection plan must account, in the very first instance, for the law of fraudulent transfers. In general, the law of fraudulent transfers, which dates back to the enactment of the Statute of Elizabeth in England in 1571, provides that the transfer of assets in anticipation of a creditor problem will be disregarded by the courts and the creditor will be allowed to enforce its judgment against the transferee of the property. B. Although minor variations exist, fraudulent transfer statutes can be found under the law of every state and almost all foreign jurisdictions, as well. C. A fraudulent transfer is often deemed to be a transfer of property that was made with the intent to "hinder, delay or defraud" either existing or reasonably anticipated future creditors. Common law usually divides creditors into three categories: 1. Present creditors - those persons of whom the transferor has notice when making transfers. 2. Subsequent creditors - those persons against whom the transferor harbored an actual fraudulent intent when transferring assets, including creditors whose rights arose after the transfer if the transferor intended to proceed with his or her affairs in a fraudulent manner or with reckless disregard for the rights of others. Gideon Rothschild

3 3. Potential future creditors - those nameless, faceless persons of whom the transferor had no awareness when the transfer was made. D. In addition, a transfer which has the effect of rendering the transferor insolvent will automatically be held a fraudulent transfer. E. Moreover, in certain jurisdictions, the mere fact that one has been named as a defendant in a lawsuit can render all transfers made without sufficient return consideration as per se fraudulent transfers irrespective of the transferor's actual intent in making the transfer. F. Under all other circumstances, however, the issue remains the transferor's intent in effecting the transfer, which generally boils down to how close in time the transfer of property was to the subsequent creditor claim. 1. It is notable that, except as specified hereinabove, it is unimportant whether or not a creditor's claim has yet coalesced into a lawsuit (which, of course, might be months or years later). G. It is, therefore, absolutely imperative that asset protection planning be undertaken as far in advance of a potential creditor claim as possible in order to ensure that any transfer of property incident to such plan is not later undone as a fraudulent transfer. III. TRADITIONAL FORMS OF ASSET PROTECTION A. Transfers to spouse - "Poor man's" asset protection 1. Potentially effective (assuming it is not later deemed a fraudulent transfer). 2. Numerous problems exist, however, in connection with transfers to a spouse, including: a. Possibility of divorce b. Spouse's potential exposure to creditors c. Loss of control over assets d. Potential gift tax consequences where spouse is not a U.S. citizen e. Estate tax issues (i.e., transferor spouse should retain in his/her own name assets at least equal to exemption amount). Gideon Rothschild

4 B. Corporate ownership 1. In the usual case (absent a personal guarantee of corporate obligations), a shareholder will not be personally liable for the debts of the corporation and thus, the shareholder's personal assets are protected from the creditors of the corporation. a. This type of protection is referred to as "inside out" protection because the shareholder's personal assets (which are outside of the corporation) are protected from the corporation's creditors (whose claims arose inside of the corporation's business dealings). b. The inside out protection is not absolute. Gideon Rothschild In the case of a closely held corporation, a plaintiff's attorney is likely to join the shareholder (in the shareholder's capacity as a corporate officer or director) in the action. The protection may also be breached via statutory and/or common-law arguments including an argument to "pierce" the "corporate veil" due to a failure to consistently observe the formalities of the corporate form. 2. The reverse, however, is not also true, and if the shareholder is sued personally, the shareholder's interest in the corporation (in the form of his or her shares) will be reachable by the judgment creditor and, in the case of a sole or even a majority shareholder, a personal creditor would be able to reach the assets of the corporation in satisfaction of a judgment through the liquidation of the corporation following execution on the shares of the shareholder. C. Limited Partnerships and Limited Liability Companies 1. The asset protection afforded by the limited partnership or limited liability company structure is based upon what is commonly known as a "charging order" protection. a. Under the law of every state it is arguably the case that if the limited partner or limited liability company member is successfully sued his or her creditor would only be entitled to a lien on the limited partnership interest or limited liability company membership interest, and would not be entitled to enforce its claim directly against the underlying assets of the limited partnership or limited liability company. b. In addition, the creditor's charging order may not necessarily entitle the creditor to become a limited partner in the limited

5 Gideon Rothschild partnership, or a member in the limited liability company, entitle the creditor to vote on limited partnership or limited liability company matters, entitle the creditor to inspect or copy limited partnership or limited liability company records, or entitle the creditor to obtain the business and tax information of the limited partnership or limited liability company (which is usually available to limited partners and limited liability company members as a matter of law). c. The sole entitlement of a creditor with a charging order is, arguably, the right to receive the distributions that are allocable to the debtor limited partner from the limited partnership, or the debtor member from the limited liability company, if and when distributions might be made. The creditor's "remedy" of being able to receive distributions from the limited partnership or limited liability company if and when distributions might be made may ultimately prove hollow in a "family" limited partnership, or "family" limited liability company situation, since it is unlikely that the general partner or manager will distributions while a charging order is outstanding. A limited partnership agreement or limited liability company agreement drafted for asset protection purposes will provide the general partner, manager or managing member with broad discretion to make, or to refrain from making, distributions from the limited partnership or limited liability company. 2. Under the tax law there is some authority to the effect that the taxable income of the limited partnership or limited liability company will be chargeable to the creditor who has obtained a charging order notwithstanding the fact that no distributions may ever actually be made to the creditor. a. Therefore, the effect of a charging order might be that the creditor will be forced to realize "phantom" income on which the creditor would have to pay income tax on a current basis. b. There is substantial doubt, however, as to whether the creditor will, in fact, actually be charged under the tax law with phantom income by reason of the charging order. In fact, it is at least as likely that, notwithstanding the charging order, the limited partner or limited liability company member will be liable to report the income of the limited partnership or limited liability company on

Asset Protection Planning (With Audit Checklist)

Asset Protection Planning (With Audit Checklist) Gideon Rothschild Gideon Rothschild, J.D., CPA, is with Moses & Singer LLP, in New York, New York. A. Introduction 1. Litigation environment creates greater